Eight Novel ETFs Looking to Break Out In 2013

With the early lockup of benchmark index licenses by ETF pioneers, innovation has typically been the only pathway to market share for new entrants to the field. To snag assets, products tracking new indexes and novel strategies have to be introduced. And marketed.

According to ETF Database, there were more than 1,440 products extant at year-end 2012 and another 950 or so in registration with the Securities and Exchange Commission. Threaded within the knot of products in waiting are eight that stand out as particularly distinctive both in terms of their unique exposures and for their potential marketing challenges. Some are complex, with lots of gears and gizmos; others are pretty simple. All, some or none could see the light of day in 2013.

First are a slew of volatility plays.

Bring On the VIXThe ALPS U.S. Equity High Volatility Put Write Index Fund is designed to track a portfolio of exchange traded put options sold against a cash position (i.e. “cash-secured put writes”). The puts are selected by the fund’s index methodology on the basis of their implied volatilities. It’s not cheap puts the fund seeks, it’s the most expensive.

By selling options, the fund will take in premium from contract buyers, boosting the fund’s returns provided the options remain unexercised and are allowed to expire. Buyers of this fund would, in essence, be banking on declining stock volatility. Thus, the fund is geared to make money from a stabilizing or rising market for the puts’ underlying stocks.

Speculative buyers of this fund must therefore be confident that the market for large-cap stocks isn’t likely to collapse during their holding period. That could be a significant marketing challenge, but it’s likely to pale against that of attracting taxable investors.

Every 60 days, the fund will write new option positions, generating substantial portfolio turnover. This portfolio’s reliance on cash, rather than in-kind redemptions, may occasionally require the sale of portfolio securities. Thus, the fund could pass through a potentially large tax liability to shareholders.

There’s a decidedly differently approach taken by the VelocityShares Tail Risk Hedged Large Cap ETF, a fund-of-funds portfolio comprised of three large-cap equity ETFs and two volatility-related ETFs.

The equity ETFs all track the Standard & Poor’s 500 Index and together represent an 85 percent allocation of fund assets. The 15 percent allocation to the volatility ETFs simulates a “tail risk” hedge. Tail risk refers to the danger of rare but severely consequential market events, such as the 2008-2009 equity nose dive or 2010’s flash crash. The hedge consists of two ETFs providing leveraged (i.e., +200 percent) and inverse (i.e., -100 percent) exposure to S&P 500 VIX futures. VIX, of course, is the S&P 500 Volatility Index, the so-called “fear gauge.”

The volatility allocation simulates a long/short straddle in VIX futures with a targeted net long exposure of 35 percent. Taken alone, this position would benefit an investor who believes the market may move sharply but is unsure about which direction that movement may take. By replicating a straddle with a long bias, the volatility allocation benefits more from a sharp upward movement in VIX futures than a sharp downward movement. Conversely, if VIX futures move slightly in either direction, the fund could absorb a loss on the volatility component.

The more significant risk associated with the volatility component is actually compounding. The return generated by each volatility ETF over a multi-day period is the result of its return for each day compounded over time and will likely differ from its daily return objective. It’s possible, in fact, that the volatility component could lose money, even if market volatility spikes higher, as a result of compounding. An investor in the tail risk-hedged ETF may intend to be long large-cap stocks and modestly long volatility, but the volatility piece is itself volatile and could move idiosyncratically.

Continuing on the volatility route is theBNP Paribas Enhanced Volatility Fund. Think of this fund as an analog of the volatility component in the VelocityShares product. The fund’s designed for investors who want to gain long exposure to the forward implied volatility of the S&P 500 Index. Here, youwant, rather than shun, tail risk.

The fund will trade an optimized portfolio of VIX futures while maintaining a collateral position in cash and fixed-income instruments. The portfolio’s VIX futures positions will range from the front, or spot, month consecutively out to the tenth delivery month.

While the VIX Index represents a measure of the current expected volatility of the S&P 500 Index over the next 30 days, the prices of VIX futures are based on the prospects for 30-day volatility on the contract’s expiration date. The spot/forward relationship means the price of VIX futures can be lower, equal to or higher than the VIX itself, depending on whether the market expects volatility to be lower, equal to or higher in the 30-day forward period covered by the VIX future than in the 30-day spot period covered by the VIX itself.

The fund portfolio rolls its positions forward through an optimized algorithm that maximizes yields in backwardated markets and minimizes losses from rolling in a contango. A backwardated market is characterized by higher prices in the shorter-term future expirations compared to longer-dated contracts. Conversely, a contangoed market exists when near-term deliveries are priced at a discount to long-dated contracts.

Perhaps the biggest distinction for the BNP Paribas Enhanced Volatility Fund is its anticipated cost. With a management fee of 156 basis points (1.56 percent) per annum, it’s bound to be one of the priciest ETPs on the market.

Simply HumanThe mechanics of the iShares Human Rights Index Fund are a lot more simple. A rather straightforward product likely to appeal to socially conscious investors, the fund tracks a slice of the MSCI All Country World Index (ACWI). The Human Rights Custom Index on MSCI ACWI, as the benchmark is formally known, is a global compendium of equities that excludes shares of companies with economic associations to countries or regimes implicated in serious human rights violations (genocide, torture, rape, slavery, forced labor and forced displacement of communities). In addition, investments in companies with substantial economic associations with repressive regimes with poor human rights records, such as Sudan, Iran and Burma, are excluded.

At last look, the ETF’s underlying index was comprised of 8,905 securities issued in 45 countries.

As simple as the fund’s investment philosophy are the fund’s primary risks. First, there’s tracking error. The fund’s investment advisor intends to use a representative sampling strategy rather than complete index replication to manage the fund. Collectively, the sample should have an investment profile similar to the fund’s underlying index, but there’s no guarantee that its returns will track the index closely. While representative sampling reduces costs and increases transactional efficiency, it also introduces error.

Second, the fund isn’t expected to hedge currency risk. Holdings denominated in non-U.S. currencies, then, are at risk of diminution due to the relative appreciation of the U.S. dollar. It’s possible, in fact, that local market gains could be swamped by foreign exchange translation costs.

Another excursion into foreign exchange risk would be possible with the launch of theiShares Chinese Offshore Renminbi Cash Rate Fund which claims to provide a daily return reflecting the increase or decrease in the exchange rate of the Chinese offshore renminbi (yuan) against the U.S. dollar. The Chinese offshore renminbi trades in Hong Kong and other markets outside mainland China.

Unlike the ETFs we’ve examined thus far, this fund will be actively managed. Substantially all of the fund’s assets will be invested in short-term securities denominated in U.S. dollars and spot foreign exchange currency contracts. The fund’s short-term securities are expected to maintain a weighted average portfolio maturity between one and 30 days.

The fund will continuously roll its spot currency positions forward one business day at a time. Any realized gains on these daily rolls could subject shareholders to substantial tax liabilities.

The risk goes beyond taxes. Investors will have to be believers in Chinese paper -- vs. the buck at least -- for this fund to make speculative sense. Over the past year, renminbi appreciated nearly 2 percent against the dollar, but not without a fair degree of volatility. Fund buyers will have to ask themselves if money market returns such as these are worth the risk. Still, renminbi’s peg to the dollar has been gradually weakening. If the Chinese currency is allowed to fully float in the forex market, volatility could increase, widening the fund’s range of returns.

Step back from the world of currency exchange to regard the more pedestrian -- or more properly, the non-pedestrian --Global X FTSE Toll Roads & Ports ETF. This fundintends to invest in the largest and most liquid companies involved in the business of toll roads, airports and seaports.

Clearly, this fund is geared to thrive in a global economy where travel and commerce are resurgent. The fund’s toll road exposure would likely benefit from the aspirations of developing economies -- particularly China’s -- for automobiles. The vagaries of goods movements via tractor-trailer rigs will also be reflected in the fund’s toll road allocation. Leisure and business travel, as well as cargo shipment volume, will likely influence the portfolio’s investment in airport- and seaport-related businesses.

Aside from the risk of a decline in global travel and commerce, fund investors will be exposed to foreign and emerging market risk.

Unlike the iShares Human Rights Index Fund, this portfolio intends to use a full replication strategy, investing in its underlying index’s securities in the same proportions as the benchmark. index. Thus, the fund adviser expects that, over time, the correlation between the fund’s performance and that of its underlying index, before fees and expenses, will exceed 95%.

The fund’s advisor intends to use a proprietary methodology to rank 25 to 30 individual commodity and financial futures contracts, selecting a sub-set that demonstrate the greatest relative strength. These contracts would then be purchased on a modified equal-weight basis. The strategy is “long-only.”

While commodity prices are generally uncorrelated to equities and fixed income securities, the degree to which the fund’s investment strategy exposes the portfolio to financial futures may increase its correlation. This, coupled with the fund’s long-only bias, may further goose up correlations.

The fund, too, is likely to generate substantial turnover. The relative strength analysis is expected to be conducted daily and drive rebalancings.

Inflated ExpectationsLastly, there’s the SPDR Barclays Capital Breakeven Inflation ETF, a fund designed to track the “breakeven” rate of inflation in the United States.

The breakeven rate is the level of inflation required for TIPS (Treasury Inflation-Protected Securities) to approximate the performance of U.S. Treasury securities with equivalent duration.

As inflation rises or falls, TIPS principal values and interest payments increase or decrease. Because of this inflation adjustment feature, inflation-protected notes and bonds typically have lower yields than conventional fixed-rate Treasuries.

The fund will track the breakeven rate with simultaneous long TIPS positions and short positions in comparable conventional U.S. Treasury obligations.

While the breakeven inflation rate represents a barometer of the market’s expectations for inflation over given period, it doesn’t measure or predict the actual rate of inflation. It’s possible that the returns of the underlying index -- and, by extension, the full-replication fund -- will not correlate to changes in the realized rate of inflation. As a result, an investment in the fund may not be an effective hedge against inflation.

Some of these products may seem to express innovation for innovation’s sake alone. Market conditions may, in fact, never favor their introduction. To boot, it’s not clear if investors actually want these exposures but given the long registration lead times, product manufacturers have to get them on the launch pad.

American statistician and management consultant W. Edwards Deming once said, “Innovation comes from the producer - not from the customer.” Perhaps the old number-cruncher was on to something.